Start here with this simple example. It’s a coin toss. Heads you win $100; tails you get nothing. How much would you pay to play? You can play as many times as you wish. Answer: not more that $50. For less than $50, you would play as often as you can. $50 is your breakeven; only a fool would pay more.

Now add Tim Geithner as your partner. He matches what you invest but you, and only you, get to set the price to play. Answer: you put up no more than $25 as the investor and that means he matches your number. At under $25 you play as much as you can. $25 is your breakeven as the investor; $50 is still the breakeven for the coin flip.

Now let’s add some of the leverage from the FDIC.

Suppose that the FDIC will loan you $40 as a non-recourse loan. You and Geithner each put up $5 for a total of $10 and, adding in the loan money, you pay $50 to play, just as before. If you get heads, you pay off the loan of $40, and you and Geithner split the rest. That means you get $30 for your $5 and so does he. Remember, you set the price to play. If you get tails you get nothing and lose $5, Geithner loses $5, and the FDIC loses $40.

Now suppose we have an auction to decide who will play.

The highest bidder wins the right to play as many times as he wishes. With this example the breakeven price rises from $50 to $70. At $70 you put up $15; Geithner puts up $15 and the FDIC still loans $40. Half the time you will win $100 and use $40 to pay off the FDIC, leaving $60 for you to split with Geithner. You will get $30 back for each $15 you play, when you win. The other half of the time you will get zero, since it’s still a coin flip risk.

Notice that the price to play went from a $50 breakeven to a $70 breakeven. This happened while the odds remained a 50-50 coin flip.

Also notice that the leverage ratio was low when you put up $15, Geithner put up $15, and the FDIC put up $40. Under the Treasury PPIP plan the leverage ratio can go as high as 6 to 1. Using the full 6:1 leverage ratio, a coin-flip breakeven point would be about $3.57 for the investor.

Here is how I get that number. You put up $3.57; Geithner puts up $3.57; the total investor’s equity is $7.14. The FDIC loans 6 times $7.14, or $42.84. Total price to play is $49.98. Let’s call it $50, which is the amount to play each time.

Notice that the breakeven auction price is now almost $93 each time. Remember you, as the private investor, are the one who sets the auction price, because you are the only one deciding the bidding. Geithner is matching you and the FDIC is loaning 6 times the equity.

The leverage and the risk transfer have raised the investor’s breakeven from a $50 auction price, if you did this all by yourself and without any leverage, to a $93 auction price when leverage is fully deployed. The risk of winning or losing is still a coin flip.

Let’s substitute a toxic asset on a bank’s balance sheet for the coin.

Instead of a 50-50 coin flip, with PPIP we have a toxic piece of a mortgage-backed debt instrument that has an uncertain value. If we use PPIP, aren’t we really inflating the price artificially? It seems to me the answer is yes.

How can we adjust for this risk transfer that allows the auction breakeven price to rise? That answer lies in how much the FDIC will charge to make the non-recourse loan. If the FDIC charges enough, it will bring the auction price back to $50 and restore the deal to neutrality. If the FDIC charges more, it will bring the price below what it would be without the leverage.

But if the FDIC underpriced the loan cost, it would then have subsidized the deal and allowed the auction price to rise. That means the seller of the toxic debt instrument got more than it was worth and the investor made a profit because of the FDIC.

Some of the risk of payment on that instrument transferred to the FDIC. That means it transferred to the FDIC insurance fund, which means it transferred to every insured deposit in every bank that pays an insurance premium into the fund. That means the depositor may be getting a lower interest rate on that deposit than he otherwise would get.

That is PPIP.

Some Questions. Will this process set a true “market price” for these toxic assets or are we using a gambler’s pricing mechanism? Has Geithner been transparent about this risk transfer to the FDIC? What will the FDIC charge investors when it assumes the 6:1 leverage risk? Will it price risk fairly or will it grant massive subsidy to banks?

Dear reader: you decide if this is a good thing or a bad thing. You decide if this is how it was presented to you. You decide if this is a sound policy solution for the US banking system or if you believe that our government has taken “moral hazard” to a new level with pee-pip?

For more details on PPIP see this weekend’s issue (March 30) of Barron’s and the columns on PPIP by Jonathan Laing and Andrew Bary. They start on page 25 and offer an investor’s view. As a money manager for our clients, the Cumberland firm will look at PPIP and may use it on behalf of clients after we have reviewed an official form of an offering document. As a private citizen concerned about my country and its policy direction, I think this reeks and stinks.

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

49 Responses to “PPIP: Heads or Tails?”

if the FED wants to set a “market price”, they can do it, but there is no law forcing private buyers to step in. The FED can buy all this crap by themselves, with whatever market price they want to set with the Taxpayer money.

it’s even simpler than making up skewed, unrealistic outcome distributions (0 or 100) to prove the point.

first, notice that the FDIC doesn’t actually loan the money as Kotok describes. the seller loans the money to the buyer – and the FDIC guarantees this debt.

Why is this an important distinction? because IF the seller truly believed that his asking price was correct, and IF the problem was truly a lack of available leverage, then the seller could have facilitated this exact trade WITHOUT the FDIC – just like MER did with LoneStar last year.

The seller could finance a non-recourse loan for the buyer, using the assets as collateral. In fact, that’s exactly what the PPIP does. The difference is that in the PPIP, the FDIC takes the risk, NOT the seller.

Thus, we can only conclude that the sellers KNOW that their asking prices are phony – as they are not willing to lend based on those valuations. The problem isn’t a “temporary dislocation” “firesale pricing” or “lack of leverage.” the problem is that asking prices are too high.

the PPIP gets the FDIC to take the lending (pricing!) risk from the seller.

Thanks KD. Yes, that is the essential issue. Govt should not be assuming risk. That is the job of enterprise. Wouldn’t a loss mitigation process make more sense than creating a financial mechanism to ‘ensure’ profits for businesses which did not manage risk properly. And why should Govt provide investing opportunities for investors. Let the investors seek out those opportunities. If the Govt has to sweeten the pot, no one should even pick up the cards. Hell, the sucker isn’t even at the table.

The current idea floated by financial institutions, and the media in partner with them, is that these derivatives may actually come back in value. That cannot and will not happen for very concrete mathematical reasons.

A CDO built in 2005 is almost certain to contain mortgages written with 105% financing with 50% DTI. Those loans are blowing up at enormous rates. Hence, since the CDO’s return is predicated on nothing more than a positive flow from the underlying securities, every tranche containing blown mortgages exceeding the modeled margin of default is a 100% loss.

Underwriting guidelines have almost returned to sane levels. The banks are lending, but the new guidelines limit those that are lent to. That has eliminated more than 50% of the possible buyers which existed 3 years ago.

The only way for any of the CDO’s, CMO’s or CLO’s to retain any value is if housing values go back to where they were in Jan 2006, and soon, before any more mortgages in the underlying MBS go into foreclosure.

My point is this; even the conduits are a time bomb, that will realize near 100% losses, unless housing values dramatically rise, right now, so no more houses (mortgages) in the MBS go bad, and give the current mortgagees a way out through sale for profit or true refinance.

Every credit derivative based on obscene underwriting guidelines will eventually be a near 100% loss. For that to be different, we need to let as many people back into the buying market as were present then to put upward pressure on housing values.

The only way to do that is to adopt, again, obscene underwriting guidelines. Because that will not happen, any and all monies given banks to cover losses with credit derivatives will be a total loss. I believe it is better the banks assume the loss. The are several hundred middle tier banks with no credit derivative exposure, and little residential or commercial RE exposure. They can and will fill the void should some “big brothers” go by the wayside.

The PPIP is nothing but a shell game, and will drag this country somewhere no one wants to go.

I love how all these “free market” guys are saying this won’t work. They claim “the banks won’t sell” and the “the buyers won’t buy” …but they’d say the same thing about any asset class before its market actually existed. It’s a tautological argument.

Buyers will buy and sellers sell, at some transaction volume, and years hence we will know who was “right.” Just like every other single marketplace.

The problem is not the government “making money,” the problem is getting the financial system fixed.

Like everything from Social Security to Defense, these things cost money. Are you angry that specialists at killing people get “all the money” from our payments to Defense? …that those darn doctors and nurses that should have been preventing and/or misdiagnosing illness all these years are the ones getting Medicare payments?

Little wonder the PPIP is structured in the manner it is, after watching the interview with Geithner and Stephanopolous, Geithner is simply a lackey for Wall St vested interests. Was infuriating. Below an excerpt on payouts to AIG.

“STEPHANOPOULOS: And some are saying you should go back and recoup on another, much bigger issue having to do with AIG, and that’s all the payments they made to their so-called counterparties. Let me show our viewers who got the money from AIG after they got a government bailout — $13 billion to Goldman Sachs; $12 billion to Bank of America; more than $30 billion to a series of foreign banks. That has upset a lot of members of Congress. Elijah Cummings and 26 other members of Congress have written a letter saying they want to know why an attempt wasn’t made to renegotiate.

Let me read exactly what they said. “Was any attempt made to renegotiate and close out these contracts with haircuts? If not, why not? What was the benefit of the decision to pay 100 percent of face value to the American taxpayers who provided the bailout funds, and how did it support the goal of ensuring the stability of the economic system?”

Now, Goldman Sachs, for example. Their chief financial officer said he had no material economic exposure to AIG. So why weren’t they forced to take a discount?

GEITHNER: George, we came into this crisis as a country without the tools necessary to contain the damage of a financial crisis like this. In a case of a large, complex institution like AIG, the government has no ability, had no meaningful ability to come in early to help contain the fire, contain the damage, prevent the spread of that fire. Restructure the firm, change contracts where necessary, and helped make sure that the financial system gets through this…

STEPHANOPOULOS: But it would have been the right thing to do, right?

GEITHNER: If we had the legal authority, that’s what we would have done. But without that legal authority, we had no good choices. We were caught between these terrible choices of letting Lehman fail — and you saw the catastrophic damage that caused to the financial system — or coming in and putting huge amounts of taxpayer dollars at risk, like we did at AIG, to keep the thing going, unwind it slowly at less damage to the ultimate economy and taxpayer.

STEPHANOPOULOS: So how about now, Goldman Sachs is taking other government money. They got this $13 billion whole from AIG. Congressman Brad Sherman and others have said, they should give that $13 billion back.

GEITHNER: George, the important thing is, we have no legal ability now. That’s why I went to Congress last week, to propose a broad change in resolution authority so that we have the capacity to do what we do with banks now.

STEPHANOPOULOS: But wouldn’t it be the right thing for Goldman?

GEITHNER: To give that money back?

STEPHANOPOULOS: Uh-huh.

GEITHNER: Look, again, the government of the United States in a situation like this has to make sure that we’re containing the damage that might come from default by a major complex financial institution. We need better legal authority to do that, did not have that authority coming into this crisis. It’s a tragic…

STEPHANOPOULOS: So nothing to be done looking back, but going forward, that’s exactly the authority you would want.

GEITHNER: Absolutely. Our obligation now, again, is to defuse and help unwind this deeply complicated problem that AIG presents. But we want to work with the Congress to put in place stronger tools, stronger resolution authority, so the government can come in more quickly, earlier, before things have passed the point of no return, contain the damage, prevent the fire from spreading, restructure the firm, have it emerge stronger, at less risk to the taxpayer. That’s what we need. We should have had this before this crisis, but we didn’t. But we need to move quickly now.

“Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves . . . I intend to rout you out, and by the Eternal God I will rout you out!” — Andrew Jackson

Anyone catch Mr. Geithner on MTP this AM? I missed about half of it, but wow…this guy is IMPRESSIVE! No wonder the President chose him as Secretary of the Treasury! He’s bright, articulate, quick witted…everything Senor Paulson was not.

I was very impressed with his performance before Congress last week as well. I have to wonder…Is my statement more true than I realized? Is the problem with Mr. Geithner reflected in usphoenix’s post in which he so disrespectfully called the Secretary “Timmie?”

Here’s what I think: Secretary Geithner is (supposedly) not very tall, doesn’t have a deep voice, and doesn’t have an imposing presence. I think that if he was a few inches taller, with a voice a few octaves lower, but with the same exact job performance, we wouldn’t be having this conversation. For the smartest animals on this planet, it’s amazing how primitive and crude our minds still are. We judge books by their covers, and our weaker intellects are unable to surmount our base instincts.

Who is the counter party? There’s only $70, maximum being put into the game, but there’s a potential payout of $100. Who loses the $100 when you or your “team” wins? This is a scam. Somebody dial 911 (if anyone answers the phone, hell – I’ll give you $100).

I couldn’t care if he had purple skin and stood 9 feet tall with big fangs. Sorry, Geithner is a lackey for the perpetrators that got us into this damn mess. His interview with Stephanopolous was terrible. He’s a lousy liar and telling the public that the only solution is maintaining in position the same players as to what got us here warrants another quote from Obama similar to that from Andrew Jackson that I posted above.

We judge books by their covers, and our weaker intellects are unable to surmount our base instincts.
———————
Man! Barry just showed how this manipulation will not give us the “true” market values. Furthermore, many other commenters have once again repeated all the arguments why this crap will remain crap.

How many more ways do we have to STATE, SHOW, REASON, DEMONSTRATE, PROVE, that we do not care how tall Napoleon is… his friggin’ plan shoves even more moral hazard down our throats???!!!

danm,
Napoleon was average in height. We remember him as a shorty because the British said he was vertically challenged in their propaganda. Shows you the power of evolutionary psychology that the myth of Napoleon’s shortness has lasted 200+ years.

I think we have so much to think about and truly assess in this nation. It seems we are having a difficult time evaluating and assessing what is of true value- period. How much do we “compensate” someone who is innovative with our money and can make us money? Is that worth 500 times more than a teacher who inspires a classroom of children to go out into the world and make good use of their talents? Is that worth 30 times less than the surgeon who can save your life should your liver be lacerated in an automobile accident? Is it worth 5 times more than the spiritual advisor who makes you feel spiritually whole?
Value is what the majority find necessary and fundamental. Can we ask ourselves “are BAC, C, and AIG fundamental and necessary? The establishment itself, maybe no- the people who work for them- yes. Can we scout out who are the talents- the positive people of these establishments and talk about them on the news? Can we highlight those talented brilliant bankers who can help us get out of this financial complexity. Because I do not know who to trust the CEO’s, the CFO’s the unnamed banker in the basement of the bank crunching numbers?
We all want our children to go to a great school, get the best healthcare, drive on the safest roads, and own the safest cars. We all want our children to breath clean- non-polluted air regardless if it causing global warming or not. We all want our children to learn how to share, not be greedy, and not to hurt others. So let those fundamental truths and basic values show us the way out. We can not all be brilliant bankers, high powered lawyers, skillful surgeons. Many of us will work for 10-20 dollars an hour and hope to save up for a somewhat comfortable retirement. So for those who can become those other people, may you make all the money in the world- it’s fine with me- i dont have the brain to invent the CDO- but because i can never really benifit from the invention- i shouldn’t be more harmed than the finacial inventor.
I think Albert Einstien was disturbed that his beautiful math was used for such great destruction.

This is a leveraged scheme to pump asset values. BTW, on MTP, Geithner himself, and it was a Freudian Slip I’m sure, called this a “scheme.” Plans are generally benign, but schemes are often underhanded or impractical by definition.

David:
Your explanation assumes that the buyer and seller are unrelated and have no association. If they have related interests, then it gets much much worse.
There is nothing substantive in the Treasury dept language that prevents the seller of (say) MBS from creating an “unrelated” third party, who can then compensate the buyer for bidding face value of the assets.

The PPIP is so easy to game it ought to be DOA. But this is Geithner, former head of the NY Fed, so what do you expect.

@Franklin411: “Timmie” has been an oft used term of endearment on this blog.

I used it primarily because my arthritic fingers have an easier go of it on my QWERTY where most all of Geithner sits under my worst fingers. It’s an un-natural name. So there. Run with that one.

I have no interest in his physical stature.

I have an interest in anyone that’s an insider speaking with “authority” before a national audience, when in fact, he’s more reminiscent of a youngster dutifully voicing the words of his Uncle Vito, the Juice Loan Shark. Lest he get kneecapped.

All of this “hearing crap” is awfully well orchestrated. No one strays from the script. Ergo, each successive “Scheme” disclosure is not released until it has been carefully rehearsed and blessed.

i think i agree that its just a shell game to keep the system going and prevent further loss of trust which may lead to bigger shock to the system.

those who think it is wrong, may be short sighted in what it takes to run a confidence game called as “economy”.

right now most of the consumers and business have a pretty bad balance sheet, if that was left on its own, we will have 25% unemployment….20% deflation…nobody will be buying anything they dont need it will be back to necessities.

people with millions please excuse me, this debate is not for you….i know where your heart lies.

but people with little or no savings and totally dependent on their job….which is almost 90% of america, do you want to cleanse the system if it can cost your job??

yes all the banks are insolvent…but maybe there is no simple solution to nationalize them and let the inefficient government run the banking system….maybe its better for the tax payers to take the losses of those banks…..i dont know the perfect solution but that only because i dont have the exact data(just like most of us here).

you like it or not…..reflation is going to happen…….it may lead to inflation but only because of speculative capital will try to hoard the commodities(i am not sure how much they can store though since consumption is going to be pretty bad for a while).

controlled inflation is the only solution to this problem brought on by debt, and its going to happen since that will benefit 95% of the people.

there will be more stimulus…government will try to hire every unemployed to fill the gap left by private sector….and i hope that it will try to put a bottom to this spiralling downfall….

i dont think we will ever go back to 4% unemployment…maybe never, maybe we will be like the european countries with 8-10% unemployment being normal…

i do see that dollar will be devalued to act as a subsidy for “made in america”….and a way to further improve employment and maybe fuel wage inflation.

so it does look like savers are going to be screwed big time (i am one of them…though not enough to retire)

@franklin411
Remember Paulson’s boss, George Bush, widely known to use nicknames such as Tangent Man, Tiny, Tree Man, Congressman Kickass, Sabertooth, for journalists and politicians. It wouldn’t surprise me if he called Paulson “Biff” or “Moose,” but not “Mongo”.

The coin flip analogy is misleading. A closer analogy would be pari-mutual betting, wherein the odds shift as players place their bets. Even this analogy is flawed though, in that the PPIP bets will not only shift payout odds as between players, but feed into the ultimate outcome of the horserace.

March 29th, 2009 at 11:45 am
Anyone catch Mr. Geithner on MTP this AM? I missed about half of it, but wow…this guy is IMPRESSIVE! No wonder the President chose him as Secretary of the Treasury! He’s bright, articulate, quick witted…everything Senor Paulson was not…

dude- is Geithner your Uncle or something? And so what if people make fun of him- it’s an easy thing to do. If a person is in the public spotlight then they are going to take some heat. And you seem to be the one who keeps bringing up Geithner’s shortcomings (no pun intended).

Sorry, we in TV land only get 105 seconds per story. Anything more and we lose track of what they were talking about. Shrink this article down to a sound byte and maybe people will care as much as about AIG bonuses.

I guess I don’t understand the first paragraph.
The game is a coin toss.
The odds of a head on any toss are 50/50.
Heads, I win $100.
Tails, I lose $0.
I may play as many times as I wish.
It would seem that paying any amount less than $100 as long as you were able to
sustain the inevitable string of losses would be a winning combination.

How is PPIP any different from the government just hiring some hedge fund or private equity hotshots to run US.HEDGE where 50% of the upside goes to the manager and 50% to the customer, with the customer providing leverage and most of the risk?

Haven’t investors been doing this for years? By their own choice? Were they suckers?

OK, so Mongo G comes up with this razzle-dazzle scheme to grossly overpay for toxic bank assets and the private investors make big bucks on lucky tranches and leave the baddest tranches with FDIC when they walk away from their non-recourse loans.

The 4 big banks now have clean balance sheets and can resume lending their virtually free money for new loans to consumers, corporations and those sweet, sweet credit cards with 30% interest & penalties.

Meanwhile the Federal government & FDIC are many trillions underwater for deficits, bailouts and proud ownership of toxic assets. The only solution is hyperinflation to render these debts to meaninglessness. The FDIC would, of course, have to thread the needle and unload these toxic assets before these million dollar homes collapse back when mortgage interest rates explode in response to hyperinflation.

You would not bid more than 87.50. You put in 6.25, Geithner joins you with 6.25 and FDIC loans you 6×12.50=75. You win 12.50 or loose 6.25. You would only bid 93 if you’re a Bayesian and convinced the coin has a bias towards the private market.

PimRock puts in $3.57, the taxpayer funds the US Treasury $3.57 (unauthorized by Congress) = $7.14 and the taxpayer-funded FDIC is then permitted to loan PimRock $42.84. Hmmm, I did not know the FDIC was chartered to create credit and extend loans. I thought they were in the insurance business, insuring deposits, not making loans, but maybe my understanding is a bit whack or a bit out of date under the new Geithner driven Obama regime. Some enlightenment from those who know whether this scheme was legal before the Geithner’s scheme or not. And if not, wouldn’t the US treasury need congressional approval under the badly trampled and abused US constitution?

In any event, PimRock’s downpayment of $3.57, with the FDIC leverage thrown in allows provides PimRock with 13:1 or 14.1 leverage. Now we all know PimRock gets special treatment from the gubmint, so I doubt the gubmint is going to require a debt-to-income ratio of 38% to determine their creditworthiness in order to service this taxpayer funded loan from the FDIC.

Nice way to explain the problems with PPIP. But your math is wrong!! When leverage is fully deployed (6:1), the value of the lottery is $87.50; not $93. You put $6.25, Geithner puts $6.25 & the FDIC puts $75 (=6*($6.25+6.25)), making the value of the lottery $87.50 (=$6.25+$6.25+$75). You only have to solve one equation with one unknown. Good ideas should not be marred by bad numbers. Numbers matter… Else you end up like Geithner…

Also you could take one more step. If you put up $25, Geithner brings another $25 & the FDIC provides $300, bringing the value of the lottery to $350, when it really costs $50. Then one of your competitors does the same for a lottery that you own. In the end, your competitor & you exchange lotteries & $25, Geithner pays each $25 (for 50% of the profits if the $50 lottery is sold for more than , and the FDIC lends each $300 cheaply with two lotteries worth $100 in total as collateral. Great deal for the taxpayer!!! No wonder Geithner will only allow asset managers he approves in this party…

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Ritholtz has been observing capital markets with a critical eye for 20 years. With a background in math & sciences and a law school degree, he is not your typical Wall St. persona. He left Law for Finance, working as a trader, researcher and strategist before graduating to asset managementRead More...

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